An experimental investigation of bank lenders' financial analysis and contracting behavior in group terms lending contexts

Wilkins, Trevor A. (1989). An experimental investigation of bank lenders' financial analysis and contracting behavior in group terms lending contexts , School of Business, The University of Queensland.

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This thesis contributes to an understanding of bank lender's corporate financial analysis and contracting behaviour in group term lending contexts. The study extends agency theory to this little-researched private loan sector of the debt market. It provides analysis and evidence of the interactions of borrowers' and lenders' interests that account for lenders' financial analysis and contracting behaviour.

To facilitate explanations and predictions about the impact of certain variables on lenders' financial analysis and contracting behavior, the study develops a micro-level theoretical model. The analysis underlying the model is consistent with recent developments in the "theory of lending" literature.

The model was applied to a restricted research setting to derive a set of eleven strategic hypotheses. The hypothesis development involved comparing the implications of the theoretical and professional literature to predict the effects of different group financial statement and contracting variables on lenders' behavior.

An experiment using experienced corporate lenders as participants was employed to test the research hypotheses. Use of the experimental method within a financial economics context has rarely occurred. However, it is particularly appropriate for investigations at the level of individual lenders.

The experimental design is a 2x2x[24] factorial relying on standard assumptions of analysis of variance. Main effects and potentially important interaction effects among management reputation, consolidated and parent company financial statements, loan covenants, and cross-guarantees were analyzed using analysis of variance. The dependent variable is the lender's assessment of term loan repayment likelihood. Assessment of loan repayment likelihood is synonymous with assessment of default risk in the financial economics literature.

Four major results were obtained. First, applicant parent company financial statements significantly affect lenders' assessments of loan repayment likelihood. Consistent with the professional literature, the results imply that the lender's primary concern in group financial analysis is to assess the applicant parent company's repayment likelihood from its own self-sufficient cash flows. This applies even in circumstances where cross-guarantees are provided, or where the group is under centralized management and control and the group's management reputation is favorable. Lenders still perceive applicant parent, rather than group consolidated statements, to be the more relevant indicators of loan repayment likelihood.

Second, management reputation in debt markets, loan covenant, and cross-guarantee factors play an important role in loan default risk assessment. The significant results confirm that lenders' behavior is consistent with the behavior implicitly assumed by the financial economics literature. Prior studies in the financial economics literature have assumed that the effects of these three factors are based on lenders' preferences and their aggregate perceptions of the increases or decreases in agency costs. The effects and preferences influence lenders' assessments of the probability of default on any given package of debt claims.

Third, consolidated statements can affect lenders' assessments. However, the materiality of the effect is conditional upon the degree of default risk reflected by the applicant parent company's financial statements.

Fourth, neither the presence of a favorable management reputation nor the provision of loan covenants has any significant impact on lenders' assessments of repayment likelihood by high-levered applicants. Lenders apparently do not place any additional reliance on management reputation to obtain funds that may be required for an applicant indicating a high probability of loan default. Similarly, they do not place any additional significance on covenants offered by managements of such high-levered applicants.